Saturday, February 06, 2010

Labor Mobility & Currency Unions

Particularly when American opponents of the European Monetary Union (EMU) claims that the problems of for example Spain or Greece proves that the monetary union is a bad idea, many people point out that their argument could be used to argue that for example California or Florida should ditch the U.S. dollar and introduce their own currencies. Since virtually no American critic of the EMU is arguing that California or Florida should stop using the U.S. dollar and introduce their own currencies, many suspect that their critique is based on the resentment of any other currencies challenging the U.S. dollar's "reserve currency" status.

Anyway, regardless of what motives American critics of the European Monetary Union may have, it is obvious that California in particular have fiscal woes very similar to Greece's and have had a more severe housing boom and bust than the U.S. average, just like Spain had a more severe housing boom and bust than the Euro are average. And since California would in fact in terms of GDP represent the sixth largest currency zone in the world (after the U.S., the Euro area, China, Japan and the U.K.), it would seem that they could do better than most with their own currency.

One of the most prominent and most passionate American EMU opponents, Paul Krugman, answered that there are two reasons why it makes more sense for Spain or Greece to have their own currencies than California or Florida. First, the United States have fiscal federalism (a federal budget that redistributes between regions) while the Euro area does not, and secondly because labor mobility is much greater within the United States than in the Euro area.

The fiscal federalism argument is true in the sense that while the U.S. has a large federal budget (larger than ever these days), the Euro area itself has no budget and the EU budget is very limited in size (only slightly more than 1% of GDP). Also, it is probably true that a common budget reduces regional differences in cyclical development. That however doesn't necessarily mean that it benefits overall growth since it in effect punishes the more successful regions and rewards the more failed regions, something which in turn harms growth.

And from a pro-capitalist/libertarian point of view, the absence of fiscal federalism is in fact something positive since it enfeebles the state. If the state can't print money at will, this reduces their power to spend. While the European Monetary Union differs in important aspects from the classical gold standard, it is similar to the gold standard in the sense that it disables the state from spending by the direct or indirect use of "the printing press".

And moreover, if the absence of fiscal federalism made a monetary union untenable, then that would have indicted the United States before the 1930s. Before Herbert Hoover and Franklin Roosevelt dramatically expanded the role of the federal government in the United States in the 1930s, federal spending on domestic (as in non-military) items was no greater than the current EU budget relative to GDP.

"But labor mobility was much greater then" someone might say. Indeed it was. The absence of a federal welfare state in the pre-Hoover era caused labor mobility in the United States to be much greater than not only in the present day Euro area but also compared to present day United States.

But, labor mobility will in fact likely increase rather than decrease regional differences in business cycles, as a larger number of people in growing regions will increase growth there while a smaller number of people in weaker regions will further reduce economic activity there.

It could justifiably be objected that reduced regional differences is not really a self-end and that the key is that overall output will be maximized and overall unemployment will be minimized. Assuming that differences in growth depends on other sectors than the housing sector (or some form of government distortion), higher labor mobility will indeed increase growth and reduce unemployment for a region.

But, as I already hinted in the previous paragraph, this might not hold if the cause of regional differences is a housing boom. The reason for that is that while immigration during booms and emigration during slumps increases and decreases respectively the supply of labor in accordance with the movements in demand of labor, immigration during a housing boom will temporarily further increase housing demand and so help worsen the bubble. Similarly, if foreign (or domestic) workers leave during housing slumps, this will further reduce demand for housing and increase the gult of unsold homes and cause further declines in construction activity.

During the housing boom of these countries, both Spain and Ireland in fact had a massive influx of foreign workers, many of whom worked in the construction industries, something which helped fuel an already unsustainably high level of housing construction activity (as these new workers of course wanted some place to live and so increased housing demand). Now particularly Ireland, but also Spain, are experiencing net emigration of workers, something which will further increase the crisis in the housing sectors in those crisis. And the story is pretty much the same in American states with particularly large housing bubbles, such as California, Nevada, Arizona and Florida.

Whatever the pros and cons of increased labor mobility in other situations, it seems clear then that it does not reduce the economic costs of regional housing bubbles, and that it is therefore not as important factor as Krugman and others claim in determining what is "optimal currency areas".

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